Rental property tax considerations each year
Your rental property can be seen on Schedule E of your tax returns, which logs rental income and expenses. The costs include mortgage interest, property tax, maintenance, repairs, utilities, property management fees, depreciation, and all other costs connected with owning the house.
If you pay points when you close your property purchase loan, you cannot fully deduct them the year they were paid like on a primary residence purchase. Instead, you must deduct points over the duration of your loan.
If your rental income exceeds expenses annually, the income is taxable just like any other income.
If expenses exceed rental income on Schedule E – which is common due to the depreciation expense line item – you’ll be able to deduct rental losses if your non-property income is up to $150,000 annually. If your non-property earnings are up to $100,000, you will be able to deduct rental property losses up to $25,000 annually. If you earn between $100,000 and $150,000, this potential deduction benefit is cut in half. And if you earn above $150,000, you are unable to deduct rental property losses. If you earn too much to deduct rental property losses, the losses can accrue as a possible offset to capital gains taxes if you sell. Ask your tax adviser whether deductions or accrual of rental losses fits your tax profile.
Rental property tax considerations whenever you sell
When you sell a rental property, you’ll pay capital gains taxes on your appreciation. It’s essential to consult a tax adviser to obtain accurate figures, but here’s a simplified formula for estimating capital gains taxes and net gain on a sale.
Subtract purchase price, expense of improvements you have made, and total selling cost (including realtor, title, and local tax fees) from sales price. The resulting number is your capital gain, and you’ll pay state and federal taxes of approximately 25 to 30 percent (based on your tax profile) on the capital gains.
Let’s see what this formula looks like in the event you bought a home eight years ago for $200,000 using 20 % down and a 30-year fixed rate of 6 percent (the interest rate at the time). A quick mortgage calculator analysis tells us that your balance is now $140,435.
Suppose you made $10,000 in improvements to the home along the way, you make lower than $100,000 annually (so you didn’t accrue any rental losses to offset capital gains), and you’re now selling the property for $300,000. In a county that has a total of 7-percent selling cost (including real estate agent commission, transfer taxes, title, and settlement fees), your estimated capital gains would be about $69,000.
Using the capital gains tax formula above, you’d have about $17,250 to $20,700 in taxes due, and you’d therefore net about $117,865 to $121,315 on the sale.
Ways to avoid capital gains taxes on rental property
This can be avoided tax hit if your intent is to buy a new rental home immediately after you sell.
You do so with an IRS benefit called a 1031 Exchange, which is named after the IRS code number. This enables you to defer paying the capital gains taxes at closing provided that you identify a different rental property to buy (in writing) within 45 days, and close the new purchase within 180 days of closing your sale.
To get the full tax benefit, the new purchase must be of the same or greater than your sales price, and also you must put every penny of net proceeds from the sale into the new purchase.
A 1031 Exchange defers rather then eliminates the tax hit in your sale.
If you plan to convert the new rental property into a primary residence at some point in the future following the exchange, the IRS has no specific rules prohibiting you against doing so. If this is your strategy long term, speak with your tax adviser on capital gains tax implications before you decide to get into your exchange.
Nick & Cindy Davis work with several investors to maintain their investment through renting the homes and managing the homes for them. If you are interested in finding out more. We are always available by calling us at 813-300-7116 or simply click here and we will be in touch.